IML comments on the current sharemarket downturn

21st January 2008

With the sharemarket having got off to a very poor start to 2008 – down almost 9 per cent in the first two weeks of 2008, IML sets out its view of the current correction, the threats posed and the opportunities presented.

Here is an update on the situation from IML investment director, Anton Tagliaferro.

The major driver of the current downturn is the fact that the US financial system is in disarray due to the sub-prime situation, the effects of which are still percolating through all markets – and the US economy.  Indeed, a US recession seems possible, which tells us that the US sharemarket could go lower before it rebounds. 

In any case, we expect very aggressive interest rate easing to come from the Federal Reserve Board over the next few months, which should help provide some support for the US stock market.  The US Government is also considering a fiscal stimulus package to help beleaguered consumers, through a combination of tax cuts and increased spending on unemployment benefits and other programs.  But we caution that a reasonably prolonged asset-price downturn for the US remains a real possibility given the huge amount of consumer debt – which IML has talked about at length at our last few adviser briefings.
 
It is important to keep in mind that the situation in Australia is not as dire – in both market and economic terms.  Here, the Federal Government runs a budget surplus, which means it has more fiscal flexibility in the event of a slowdown in the economy.  In addition, the $1 trillion superannuation pool should support domestic equities in a stockmarket downturn, particularly given the value of franking credits to super funds.  In a normal week, more than $460 million is directed into the Australian stockmarket by superannuation funds – this should help to be a very meaningful supporting factor for quality stocks in the market.

In the business world, Australian employment levels and growth remain strong, and there is a backlog of infrastructure projects in the pipeline to help the shipment of the huge mine expansions that have already been committed to.  The recent tightening bias of the RBA and the possibility of further interest rate increases is testament to the strength of the Australian economy.  In addition, there are further income tax cuts scheduled for July 2008 and the drought appears to be finally over with the rural economy in Australia anticipated to perform a lot better in the years ahead.
 
While in our view share prices of many quality Australian stocks have been now oversold, the falling share prices of others will continue given the unsustainable growth expectations that have been priced into many of these stocks.  We regard this as a good opportunity to buy further shares in good quality companies.  The current downturn is a process of sorting out of the good from the bad – where the excesses of a five year bull market will be purged.
 
How IML's portfolio is positioned:
 
1. We have very deliberately had little exposure to companies that derive large parts of their earnings from the US.  These earnings will be severely curtailed in a US recession.  Prime examples include James Hardie, News Corporation, Billabong and Westfield.  IML continues to reassess these companies and may consider building positions in the event of further share price depreciation when valuation metrics become more appealing.

2. We remain skewed to defensive stocks and are buying more in weakness.  For example, Telstra and Amcor; each boasting healthy, sustainable yields, defensive earnings streams, strong balance sheets and great cashflows.  In addition many of these companies are, in the main, exposed to the Australian economy.
 
3. We remain cautious on many financial stocks due to the continued credit and stockmarket turmoil.  While our current holdings in the major Australian banks have been detrimentally affected by the current downturn, we expect them to recover in the near future as the sharemarket regains its poise.  In contrast we continue to have zero exposure to investment banks such as Macquarie Bank and Babcock & Brown.  We also have zero exposure to financial stocks which are almost totally reliant on the stockmarket for their earnings - stocks like AMP, AXA and ASX.  In our view the earnings of these latter companies will be severely hit by a stockmarket downturn.  In contrast, Westpac, which remains predominantly a retail housing bank remains our preferred banking exposure, given its focus on the Australian banking franchise.  In fact, last week IML used weakness in the sharemarket to top up on our holding in Westpac.
 
4. We continue to avoid companies which in our view are over-geared or have unsustainable business models.  The obvious examples being Centro and MFS.  Indeed we continue to avoid fancy investment bank stocks like Allco or  most other real-estate stocks, generally referred to as LPTs, because in our view stapling, overleveraging and financial engineering has made LPTs an extremely risky sector which is likely to be very adversely effected in a downturn.  This has been a core message from IML for a number of years at our briefings and in our newsletters.
 
5. We continue to avoid many "growth" stocks that in our view have continued to look expensive in the last year or so - here we are talking about stocks like Worley Parsons, Toll Holdings, Aristocrat and Brambles.  We are closely monitoring the shares of many of these companies as at some stage, we will be buyers of some of these stocks when we believe they represent attractive value. 
 
6.  We continue to have a limited exposure (around 12 % of the portfolio) to the Resource sector and only in high-quality, profitable companies with long-life reserves such as BHP, RIO, Alumina and Woodside which we believe should continue to do reasonably well given the continued healthy level of many commodity prices such as oil and iron ore.  We continue to shun speculative resource companies like Fortescue Metals, valued recently at $17 billion, despite not having yet shipped  a gram of iron ore. 
 
7. We continue to maintain a good exposure to companies with direct and indirect exposure to the rural sector, as these should do well in the years ahead.  Examples include Graincorp, Ridley, Incitec Pivot and Fairfax (which is now the owner of Rural Press, the largest rural newspaper group in Australia).

Conclusion:
 
While in the current broad sharemarket downturn, all stocks are being negatively affected, we remain comfortable with the stocks held in our portfolio and believe that when the sharemarket regains its poise, the share prices of the majority of the companies we hold will recover.  As mentioned earlier, while the US economy continues to be in turmoil and a downturn seems inevitable, the Australian economy is in a very different situation and continues to travel well.  In this environment, good quality companies should continue to grow their earnings and dividends in the years ahead, which will help their share prices recover and perform well in future years. 
 
For this reason, we are using the current sharp fall in the sharemarket, to top up on many of our preferred shares in preferred sectors that in our view are attractively priced - as referred to in points 1 to 7  above.